It’s Time to Kill Surface

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“The question that needs to be asked and answered is why hardware.”

To Satya Nadella’s credit, he provided not just the answer, but the question as well. And, looked at narrowly, there were good things seen – and not seen – at Microsoft’s Surface event. Having clearly failed as a mass market device, it makes sense to focus Surface and more clearly define its use case. And, if that use case is productivity, then it also makes sense to kill Surface mini. That Nadella allegedly did just that is a great sign. Now he just needs to kill the whole line.

I actually think a useful way to understand the Surface problem is to think about the Xbox.

It is by focusing on the console world that one arrives at the conclusion that the Xbox, all things considered, is a success and something Microsoft can hang its hat on. In fact, that’s exactly what nearly all Microsoft employees, from executives to rank-and-file, do whenever questioned if Microsoft is innovative. “Look at the Xbox! Look at Kinect!” is their refrain.

The problem is that winning at consoles is a small goal, one wholly different from the reason Xbox was created in the first place. For many years now Microsoft has been focused on “Three Screens and a Cloud,” the idea that they as a platform provider ought to have a presence on your desk, in your pocket, and in your living room, all tied together by the cloud. While that specific formulation arrived somewhere around 2009, that vein of thinking was central to Xbox’s creation; the console aspects were meant to be a trojan horse, giving people a reason-to-buy the Xbox (and not a Playstation); the more computer-type aspects would then be added over time until an Xbox was to living rooms what PCs were to every desk in every office and every home (running Microsoft software).

It was this original goal that contributed to the current Xbox One disaster; Microsoft’s newest console is not only underpowered relative to the PS4, it’s also $100 more expensive (due to the mandatory Kinect), and launched with a terrible wave of publicity surrounding its always-on nature. The Kinect and connectedness were both included to help the Xbox One fulfill its goal of being the primary box in your entertainment system, controlling not just games but also live TV with your voice. Unfortunately, it doesn’t work that well for entertainment, even as it has hurt Microsoft’s ability to compete for console buyers. Thus, Microsoft has spent the last year walking back many of the main features of the console, including its DRM system, its connectedness, and, last week, offering the console without the supposedly essential Kinect to make it $100 cheaper. Now it’s the same price as a PS4, but still less powerful and with the same dark cloud.

Here’s the bigger problem though: even if the Xbox One worked perfectly as an entertainment center, it would still cost $499.1 For those not good at math, that’s $400 more than an AppleTV, and completely unapproachable for anyone who does not care about gaming. In short, it is not enough to consider how the Xbox is doing relative to consoles; the Xbox must be evaluated based on how it is aligning with and contributing to Microsoft’s overall strategy, and in that light, it is an unmitigated disaster.2

So what about Surface?

What the Xbox example illustrates is it is not enough to consider whether or not Surface in isolation is a successful (i.e. profitable) product (although, like the Xbox for much of its existence, it’s not). Rather, we need to consider the overall goals for Surface. As best I can tell there are three:3

  1. Surface was the physical manifestation of Windows 8. Back when I was a category manager for the Windows 8 app store, trying to explain Windows 8 to developers,4 Surface was incredibly useful for explaining Microsoft’s vision of moving seamlessly between work and play with one device – and why you might want two operating systems on one device.5 Not that Surface was made for my personal benefit, of course; rather I believe it was intended to help sell Windows 8 to all of Microsoft’s stakeholders, including OEMs, developers, enterprises, and end customers.

  2. Microsoft did not believe their OEM partners were capable of competing with Apple. Certainly there are no public statements to this effect, but I can tell you that internally most of Microsoft’s OEM partners were viewed with disdain, being resolutely focused on the bottom line and unable or unwilling to make something of Apple-like quality. Correctly understanding that things like fit-and-finish were that much more important in a personal device like a tablet, Microsoft decided that if they wanted hardware done right, they had to do it themselves.

  3. By making their own tablet, Microsoft could reap absolute margins similar to what they enjoyed while providing software for PCs (although the margin percentage would be lower). Microsoft traditionally captured about $115 per PC (through Windows and Office licenses), but in the tablet category, $115 renders OEMs uncompetitive, especially compared to using Android. Instead, Microsoft could sell Surface for $499, with a 25% margin, which comes out to $125, about the same amount Microsoft is accustomed to earning on a device. Were this strategy successful, it would allow Microsoft to maintain its bottom line (and significantly increase its top line) even as PC sales declined in the face of tablets.

These goals must have been important, because Surface came at a significant cost. There was the actual cost of hiring the right employees, the tooling, the factories, but more importantly, there was the cost of competing with Microsoft’s most important partners – the OEMs (and Intel, when it came to the ARM-powered Windows RT). Sure, said partners perhaps hadn’t invested as much in R&D as they could have, but part of it was because Microsoft (and Intel) had long since bled them dry; surely Surface would further demotivate them.

So then, how has Surface fared?

  1. Windows 8 is a failure, rendering reason 1 moot. In fact, from what I understand the Windows group is laser-focused on simply making Windows acceptable to their enterprise base, which has been very vocal in their displeasure.

  2. Every version of Surface has been a high quality device, on the same general level as Apple. So I guess reason 2 is a win. The problem, though, is that Surface’s sales numbers show that device quality is not the primary sales driver for Microsoft customers. In other words, Surface is the tablet equivalent of the HTC One: it is high end hardware in a market where Apple has already taken the high end. Both Surface and One are thus stuck in the middle, appealing to no one.

  3. Contributing in a meaningful way to the bottom line entails selling at much greater numbers than Surface has to date. Remember, volume was always the goal; that’s why Microsoft made so many Surfaces that they had to eventually take that $900 million writedown on unsold inventory. Clearly this goal has failed as well.

Meanwhile, Sony is leaving the OEM business, Dell is restructuring, HP can’t decide whether to sell or not; Acer is barely afloat; only Lenovo seems to be prospering (and now Surface Pro is aimed directly at their Thinkpad lineup). When you consider the original goals, none of which have been met, and the original dangers, all of which have come to pass, the only conclusion is that Surface is a failure.

So then, the question must be asked, as Nadella did, “Why hardware?”

We are not building hardware for hardware’s sake. We want to build experiences that bring together all the capabilities of our company from our cloud infrastructure to our application services to our hardware capability to build these mobile-first productivity experiences. That’s the mission.

This here is the greatest danger of forgetting your original goal; you start making up new ones, that are basically “because we need it to exist.” The hardware capability that Nadella claims Surface leverages only exists because of the decision to make Surface. Nadella is basically saying Microsoft needs to make Surface because Microsoft makes Surface. With that sort of reasoning, you can continue on a wrong path forever, just like the Xbox.

To be fair, from what I understand it was Nadella himself who killed Surface Mini, likely spelling the end of the road for Windows RT.6 Assuming this is true, Nadella should be applauded for making a tough decision based on the world as it is, not the world that Microsoft wishes it were.

Moreover, Microsoft is doing just that when it comes to the cloud and application side of their business. It actually rather pains me to write something so negative, given the dramatic transformation Microsoft has undergone over the last few months.7 However, when it comes to PCs, Microsoft needs to focus on fixing Windows 8, and leave the devices up to its partners, especially Lenovo. Lenovo knows how to compete in mature markets,8 makes great hardware, and Microsoft should see them as their best partner, not a competitor (which, with the business-focused Surface, they necessarily are).

It’s time to kill Surface.

  1. Believe it or not, until a couple of weeks ago you also had to pay for an Xbox Gold subscription to even use Netflix – which, of course, you also had to pay for ↩

  2. There is no group more oblivious to this reality than the Xbox team. They have long seen themselves as too cool for the rest of the company, limiting access to their buildings and generally treating other divisions like crap ↩

  3. While I previously worked for Windows, I had no insight into Surface ↩

  4. A red flag to be sure ↩

  5. I know that’s not technically correct, but it’s how it is perceived, and fairly so ↩

  6. It’s actually kind of a bummer; Windows RT was a very clever operating system once you learned it (which, admittedly, was part of the problem), but it never had the app support to make it viable. I suspect that future small tablets will be based on Windows Phone ↩

  7. While Nadella is getting most of the credit, obviously much of this work had to have begun under Ballmer, who deserves credit for his graciousness ↩

  8. More on Lenovo tomorrow ↩

Podcast: Exponent Episode 004 – Technology and Politics

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On the newest episode of Exponent, the podcast I co-host with James Allworth:

Are the recent debates on net neutrality, the protests of Google buses, even SOPA a sign of things to come? Building on yesterday’s article The Net Neutrality Wake-up Call, we discuss the intersection of technology and politics.

  • Why do people in technology tend to dislike politics?
  • Is net neutrality really that important and understanding open loop unbundling
  • The tech industry and creative destruction: is it good for society when companies go out of business?
  • The impact of money on politics
  • Why tech and politics are on a collision course
  • What we can do to effect change on an individual basis

Links:

Show Link

Note to listeners: the Stratechery.FM feed is now redirected to Exponent (although the archives remain on Stratechery.FM). If you have subscribed to both, just delete one or the other. Thanks!

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The Net Neutrality Wake-up Call

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Sometime in the summer of 2002, having just graduated from university and determined to change the world, I was driving home from Albert Lea, Minnesota formulating my resignation letter.

After graduating I had, rather naively I suppose, assumed that politics was the best means to effect the change I desired, and so had taken a job on a significant political campaign. The work was hardly glamorous – lots of parades and handing out stickers – but that meeting in Albert Lea, where I had to listen to a local bemoan how immigrants were ruining the country, force a smile and say “The [candidate] hears your concerns” or some other sort of drivel, was simply too much. Real politics, I had come to learn, was a whole lot different than the ideal I imagined as an editor of the university paper. Real politics was about looking naked bigotry in the face, and somehow controlling my gag reflex.

So I quit.

Last week the FCC held a hearing about Net Neutrality, complete with protesters and stern editorials from tech sites everywhere. The message was uniform: net neutrality must be preserved, no ifs ands or buts. It was all deeply unserious.

I’ve written and spoken about net neutrality a fair bit at this point – see Netflix and Net Neutrality, or listen to this podcast – so I won’t dwell on this specific point for too long, but the basic issue is that broadband capacity needs continue to increase, which requires ongoing investment. It ought to go without saying, but said investment is not free; I understand and in principle agree with the argument that internet access should be regulated as a common carrier under Title II of the Telecommunications Act, but that does not address the need for ongoing broadband investment, and calls for reclassification, to be taken seriously, must include proposals for ensuring the US doesn’t fall even further behind the rest of the world in broadband penetration, speed, and capacity.

Specifically:

  • Government control of the “last mile” would guarantee net neutrality, but then taxes must cover the investment necessary for upgrading our infrastructure. If this is the best plan, then calls for net neutrality ought to be combined with local activism pressing city and state governments to prioritize funding accordingly

  • Open loop unbundling, which means separating ownership of the last mile infrastructure from the provision of Internet services, requires compelling Comcast et al to open their infrastructure to anyone who wants to be an ISP (this is how it works in many countries in the world, including almost all of those with vastly superior broadband speeds and capacity). However, the P/E ratio of your typical utility is far lower than that of a monopolistic ISP; enforcing open loop unbundling would truly be a battle, threatening billions in shareholder value (this is the best outcome in my opinion)

  • Usage-based pricing, where you pay for the capacity that you use, would properly incentivize ISPs to support net neutrality, but would be strongly opposed by many in the tech industry who do not want customers keeping track of what services are bandwidth hogs (Hi Netflix!), or choosing slower speeds to save money

Or, we could have the situation we have now: emotional appeals for net neutrality on one side, with ISPs arguing they have the right to maximize the economic utility of their networks by means that most consumers will never see (i.e. making content providers pay for fast lanes) on the other, and only the latter includes a solution for incentivizing ongoing investment.

I presume many of my readers work in technology; if you were deciding between two potential alternatives, one backed with an emotional appeal about one priority, and the other by data and a clear articulation of how a different priority would be addressed, which would you choose? I suspect most would choose the one supported by data. In other words, it’s not enough to insist that a position is morally right; it behooves us who believe in net neutrality to work through how the US can balance net neutrality with the need for ongoing broadband investment, fashion a case for our position, and then build a political movement that makes our plan a reality. That is being serious.

I sometimes fear that the tech industry as a whole learned the wrong lesson from the SOPA debate a few years ago. In that case much of the tech world came together at the last minute to defeat a terrible piece of legislation. It was certainly a great outcome, but I very much wonder how often the last-minute protest card can be played. Wouldn’t it be better if we never got to the moment of crisis at all?

The Daily Dot posted a list of companies that have spent money lobbying for and against net neutrality. It’s their introductory paragraph, though, that gets at the real problem:

With the Federal Communications Commission’s (FCC) decision to move forward with a controversial proposal that threatens net neutrality and the open Internet, lobbying activity looks like it has reached a fevered pitch. But for the companies involved—especially the telecom companies that are eager to be allowed to charge more for a “fast lane” of Internet service—lobbying has been at a fevered pitch for almost a decade.

Perhaps you will be surprised to hear that the “real problem” I am referring to is not lobbying per se.1 Rather, it’s the fact that only net neutrality opposers have been playing the game for “almost a decade.” Just like SOPA supporters, “fast” lane advocates have been making their case for a very long time, and the tech industry has been largely absent. Sure, we’re making a fuss now, but note that at last week’s hearing the FCC approved the fast lane approach. Last minute protests didn’t work.

It’s no longer enough to just complain. We as an industry need to complain with solutions, and do it on an ongoing basis.

I care deeply about the net neutrality debate, but the reason I am writing this is my fear that what we are witnessing is the start of a pattern that will hurt tech industry in the long run. Those who are injured by the impact of technology will diligently make their case in the political realm, while we in the industry who genuinely believe we are changing the world ignore the messiness of politics. And then, suddenly, we will be blindsided again and again by unfavorable legislation or regulation, at which point we will raise a fuss, with ever decreasing effectiveness.

The truth isn’t just that technology has had an impact on society, but that it is only getting started. A few months ago, in FiveThirtyEight and the End of Average I wrote about the power curve in journalism; this idea, though, is broadly applicable to every field touched by technology. The ease of communication and distribution on the Internet is rendering vast swathes of the economy uncompetitive, even as certain sectors, companies, and individuals reap absolutely massive profits. I am by no means saying this is a bad thing, but I am certainly sympathetic to those who can no longer compete. I am also extremely concerned that recourse for these changes will increasingly be sought through the political process without tech having a seat at the table, much less a coherent solution for dealing with the human fallout of technological progress.

We as an industry absolutely need to wake up. SOPA, net neutrality, the Google bus protests – all of these are of a piece, and they are only the beginning.

I understand that politics is messy, and leaves one feeling just a bit queasy. I’ve been there, driving home from Albert Lea. But that queasiness is not a function of politics in the abstract, but the reality of any institution concerned with the behavior of humans. I am familiar with the desire to escape, to put one’s head down and do work that makes one proud, but I don’t know how much longer we as an industry have the luxury. I also know how easy it is to look at politics with a defeatist attitude: how much of a difference can one person make? And yet, working at scale is exactly what we as an industry are good at! Every business model in the Valley is predicated on the idea of serving massive groups of customers with easily repeated processes and software. We can do this.

The world is changing because we are changing it, just like we all wanted to, and now it’s time to grow up and deal with the consequences in a serious way. I truly hope that the fight for net neutrality will only be the beginning.

  1. Although I absolutely agree that we need to reform how we deal with money in politics ↩

Announcing Volume Discounts + The Week in Daily Updates (Week 4)

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I am pleased to announce that you can now purchase and manage multiple licenses for the Stratechery Daily Update (or Update & Access):

  • There is a 10% per-license discount for 2 or more licenses
  • These accounts may be set up and managed centrally or on an individual basis
  • Volume licenses are only available on an annual basis, and do not auto-renew

To order, please visit this page.

In addition, if you wish to convert your membership to a volume plan, please contact me directly.

The main page content on Stratechery is free for all readers, but I also offer the Daily Update via email and RSS for $10 per month/$100 per year.1 This is a selection of items that were sent out in this week’s Daily Updates. To sign up, visit the Membership page

Microsoft Cloud Announcements

Posted on Tuesday, May 13, 2014

Microsoft made a whole bunch of cloud announcements at the opening of their annual TechEd conference, including a host of services to enable hybrid clouds (combining on and off-premise services), new types of cloud storage, and considerable enhancements to their security offerings.

What jumped out at me, though, were several of their mobile and developer offerings.

From Mary Jo Foley’s writeup of Mohoro, Windows-as-a-service:

Mohoro — known officially as Azure RemoteApp — allows users to deliver Windows Server applications on a variety of devices. The accompanying remote desktop client apps will run on Windows, Mac OS X, iOS and/or Android.

From Ryan Faas’s writeup of Microsoft’s enhancements to its Enterprise Mobility Suite:

One of today’s biggest announcement is management of Office mobile apps across multiple platforms including iPad, iPhone, and Android through Intune and Office 365. The management capabilities will be rolled out later this year and mark Microsoft’s entry into the mobile app management (MAM) space.

From Peter Bright’s writeup of Visual Studio’s Cordova integration:

At its TechEd conference today, Microsoft announced the next step in its “mobile first, cloud first” strategy with a preview of Apache Cordova support in Visual Studio. Cordova is a toolkit for building apps for iOS, Android, and Windows using HTML, CSS, and JavaScript. With the Cordova integration, Visual Studio will directly support building apps for all of these platforms.

Emphasis mine, but perhaps Microsoft’s as well. iOS and Android are officially Microsoft target platforms, and not a moment too soon. In fact, while it often takes an impossibly long time to turn a company like Microsoft, it’s truly impressive how quickly things can happen once they are finally moving in the right direction. There is absolutely an opportunity to be a platform on top of a platform for iOS and Android; as I’ve noted in these updates, Facebook is pursuing that on the consumer side, and Microsoft is finally seizing their opportunity on the enterprise side.

Pinterest Launches Promoted Pins

Posted on Wednesday, May 14, 2014

From Techcrunch:

Last fall, Pinterest announced it would begin experimenting with advertisements on its service in the form of “Promoted Pins,” which would be featured placements from select retailers and other businesses. Today, the company says that it’s expanding on these earlier tests with the rollout of a paid test of Promoted Pins. These pins will only appear on the search and category feeds, says Pinterest.

A small number of brands from across different industries are participating at launch, including ABC Family, Banana Republic, Expedia, GAP, General Mills, Kraft, lululemon athletica, Nestle (select brands), Old Navy, Target, Walt Disney Parks and Resorts and Ziploc.

Pinterest says this test group is being kept intentionally small, so that it can collect feedback prior to opening up the paid advertisements to more businesses throughout the year.

I have long been bullish on Pinterest (although broader interest definitely seems to have stagnated), but have been very puzzled at how slowly they have been moving on monetization. In fact, the two are related; to my mind, the Pinterest monetization model seems quite obvious.

Think about the biggest ad platforms out there:

  • Something like Yahoo simply has some modicum of attention, but little to no data. They charge the lowest rates
  • Facebook has very impressive demographic information, but when you’re on Facebook you’re not necessarily looking to buy something, limiting some upside. That said, this has proven to be different on mobile, where app installs have been especially profitable
  • Twitter understands your interests, potentially leading to even better targeting and theoretically higher rates (Twitter’s rates aren’t bad, but are still half of Facebook’s)
  • Google has long been the king, simply because they are the service you use when you have a high intention of buying; if you need a lawyer, you search Google

What makes Pinterest so interesting is that it is very aspirational. For serious users Pinterest arguably knows more about what you dream about than any other Internet service. Moreover, their strength with women especially makes them an ideal partner for companies seeking to serve that demographic. There is also a bit of purchase intent as well; think about someone planning a wedding or building a house, who is collecting ideas on Pinterest. They are a prime audience for advertisers.

However, despite this obvious angle, Pinterest has been exceptionally slow to roll out any sort of advertising, and I suspect it’s due to flatlining growth. As Twitter is demonstrating, having a good signal is not enough; you need scale as well.

Still, this is a good sign and something I will be keeping a close eye on.

The full list of topics covered this week in the Daily Update include:

  • Google v Oracle
  • Mobile Gaming and Gambling
  • 3rd Party Mobile Platforms
  • Microsoft Cloud Announcements
  • Cordova v Windows RT
  • Xbox Silliness
  • Pinterest Promoted Pins
  • ISPs and Regulation
  • The Right to be Forgotten
  • Square Retrenches
  • Tencent Crushes Earnings
  • Cisco and the NSA
  • Xiaomi Releases Tablet
  • Pinterest Raises $200m
  • Zendesk IPOs

To read all of these updates and to receive future updates, please visit the membership page and sign up!

I’d like to thank all of Stratechery’s subscribers for their support, and for making this site possible.

  1. There is also an access option for $30 per month/$300 per year which gives you access to me personally to ask about the topic of your choosing, a private message board, and virtual and in-person meetups ↩

Announcing Exponent, my podcast home going forward

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tl;dr: My weekly podcast will from now on be at Exponent.FM. Please resubscribe.

As those of you who follow me on Twitter may know (or who heard my appearance on The Talk Show with John Gruber), I kind-of-sort-of started a podcast with James Allworth called Exponent. Unfortunately we ran into some difficulties and, wanting to have a podcast to accompany this site, I instead launched Stratechery.FM with Jon Nathanson.

However, James and I have figured out a way to move forward with Exponent, and I’m super excited to be moving forward with the original plan: Exponent (not Stratechery.FM) will be my primary podcast from now on.

I want to thank Jon for being a really great co-host; we’re exploring ways to continue to work together on Stratechery.FM with a slightly different format, so don’t unsubscribe just yet, but for now, I’d love it if you checked out Exponent (especially if you decided Stratechery.FM wasn’t for you). Exponent will be the podcast that I do weekly.

This week we recorded a fresh episode focused on Apple’s (alleged) acquisition of Beats. I think it was really interesting, and absolutely builds upon the piece I wrote earlier this week. James is quite the skeptic, and echoes the concerns of many of you.

Topics covered include:

  • The rationale for the acquisition
  • The difference between making and recognizing market opportunities
  • What makes Apple uniquely capable of building revolutionary products
  • Apple’s previous responses when threatened in music
  • How to think about mergers and acquisitions
  • How to best motivate employees

You can find the episode here.

To reiterate, this is a separate podcast from Stratechery.FM, so you will need to resubscribe. I apologize for the back-and-forth, but I think Exponent has a chance to be really great, and I hope you check it out.

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Thanks for listening.

Why Apple Is Buying Beats

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That’s a bit of a presumptuous headline:

  1. The sale is not yet confirmed UPDATE: The deal was confirmed on May 28
  2. It’s likely no one outside of 1 Infinite Loop will ever likely know the true reasons

Indeed, as Benedict Evans wrote in his weekly newsletter:

The deal [is] something of a Rorschach Blot – people who think Apple has lost its way see this as proof, while people who don’t assume there must be some other piece to the puzzle (TV? wearables?) that we can’t see to make this deal makes sense.

I’ve consistently placed myself somewhere in the middle on Apple: I believe their high end position is secure, but that the high end market is increasingly saturated, making consistent growth a challenge. I think that reality is as good a place as any to start when thinking about this deal.

Apple’s Need for Growth

In an ideal world, Apple could simply focus on making the best possible Macs, iPhones, and iPads, and sell what the market would bear. Unfortunately, life as a publicly traded company isn’t so simple, particularly one with the scrutiny of Apple. Stock price has little if anything to do with past performance (this is why pointing to record quarters as evidence the stock is underpriced misses the point). Rather, a stock’s price is about future earnings. If those earnings are expected to grow, then the stock will be higher relative to today’s earning; if the earnings are expected to be flat, it will be significantly lower; if the earnings are expected to decline, it will be lower still.

This matters for Tim Cook and the Apple executive team not only because of activist shareholders, but also because of the role an appreciating stock plays in employee retention. While a sense of mission is the primary driver for those willing to endure a very difficult workplace, knowing you’re getting rich certainly helps.1

So the need is evident; it’s the means that are much trickier.

Apple Has No Clear Means of Growth

Apple’s growth, or lack thereof, is dominated by the iPhone. Last quarter it accounted for 57 percent of Apple’s revenues after fully realizing the upside from the China Mobile deal (the iPad was 17 percent, the Mac 12 percent, and iTunes nine percent); unfortunately, that was the last of the low-hanging fruit when it came to obvious levers for iPhone growth. I don’t think Apple will ever truly go downmarket; beyond the risk of cannibalization, it’s absolutely the case that the iPhone’s premium status is one of the leading reasons-to-own in China in particular. That said, I don’t think the iPhone is at risk for disruption either. Instead it will grow by single digits, befitting its ~20% share of the still-growing smartphone market.

Meanwhile, the iPad has plateaued, the Mac is growing in a shrinking market, and iTunes app revenue is growing as music revenues decline. None are likely to dramatically offset the iPhone.

There is no next iPhone

The standard response of Apple’s defenders is confidence that the “next iPhone” will solve the growth conundrum. After all, Apple created the Mac, iTunes, the iPod, the iPhone, the iPad, surely something else is just around the corner. But while I agree that Apple is a black swan, uniquely able to create revolutionary new products, this confidence sells the iPhone’s massive success and place in history short.

If you look back over the history of technology, there have been four epochs: the mainframe, the PC, the Internet, and mobile. Each of the first three lasted for about 15 years; we’re in year seven of mobile, and there are no challengers in sight. Based on history, I think it’s fair to assume that iOS and Android will be the primary platforms until 2020, give or take a few years.

In other words, I believe the iPhone will be Apple’s chief revenue driver for at least the next five years. Something like the iWatch may be interesting, but it’s unrealistic to expect it or any other product category to drive Apple’s growth in a meaningful way, at least in the short term. So Apple needs lots of small revenue drivers in place of one big one. And that means accessories.

Apple Accessories and the Case for Beats

Apple has long had two types of products: personal computers (the Mac, iPhone, and iPad), and accessories for those personal computers (the LaserWriter, iPod, and AppleTV). These accessories have been the manifestation of how Apple sees its personal computers being used: the LaserWriter enabled the Mac to be used for desktop publishing; the iPod made the Mac your digital hub; and the AppleTV emphasizes the iPad as the center of your entertainment.2 Notably absent is a leading accessory for the iPhone.

This, then, is the first justification for buying Beats. As I noted immediately after the iPhone 5S launch, Apple has clearly decided to position the iPhone as an aspirational device, embracing its upmarket status and emphasizing its “coolness”. And, given that positioning, it’s difficult to think of a better accessory than Beats.

I’ve been alternately amused and annoyed at geek kvetching over Beats “quality.” For the majority of the population, sound accuracy ranks very low on the list of what makes a pair of headphones great (and, for those that prefer an unnatural bass-heavy sound, accurate sound is a detriment). What Beats realized is that a pair of headphones is one of the most visible items you own; most people don’t choose their apparel based primarily on technical appropriateness, but rather on fashion and comfort, yet most headphone makers emphasize the former. Thus, when it comes to fashion and comfort Beats is so far ahead of the competition that it’s laughable.3 Meanwhile, you can’t find a picture of a musician or athlete without Beats headphones, leading to massive mindshare among young people especially.

The Beats business model is also very Apple-esque: sell a commodity hardware product with a significant markup based on the experience of owning them. And, like Apple, it’s a lucrative one: Beats was reportedly on track to earn $1.4 billion in revenue in 2013, with a commanding 60%+ share of the over-$100 headphone market. Apple’s worldwide distribution could drive that figure significantly higher over the next few years, providing a small but noticeable impact on, you guessed it, growth, both top and bottom line.

Moreover, the Beats music service fills a big hole for Apple; iTunes downloads are declining rapidly, which is problematic not just for revenue but also as an indicator that iTunes is increasingly not a differentiator for Apple hardware. Beats Music could potentially plug both holes.4

Ultimately, Beats solves a lot of problems for Apple: it provides a meaningful revenue stream, it fixes their streaming music hole, and it’s an aspirational music brand that is increasingly rivaling Apple itself with the next generation.

Why, then, the angst among Apple fans in particular?

What is Apple

I think the overriding sentiment among Apple fans is that this move feels so un-Apple-like. Sure, $3.2 billion isn’t much for a company that made $9.5 billion in profit last quarter, but Apple’s previous largest purchase was Next for a mere $400 million. Moreover, Beats’ best attribute is its brand; would Apple really allow that to live on? And if you’re going to make a streaming music service, why not build it on the most popular digital music service in the world? And while Beats may provide an experience, where is the software differentiation that makes Apple’s hardware unique?

Furthermore, as impressive as Jimmy Iovine and team might be, there doesn’t seem to be a great fit with Apple’s tight-lipped culture. And, in general, acquisitions are hard, require a lot of executive attention, and rarely turn out well in the consumer space in particular.

As I’ve contemplated this acquisition, I’ve returned often to my time at Apple University. A central tenet the team emphasized again and again was that Apple was an interlocking organism that relied on multiple characteristics to make it go. One of these was that Apple was functionally organized; there were no product divisions, and the only P&L was the one reported every quarter by the CEO. As I wrote after Microsoft’s reorganization (here and here), this sort of organization is great for developing a few very high quality products, but it does not scale to multiple product lines. Everything connects at the executive level, and there simply isn’t enough time in the day to provide the appropriate level of focus and coordination to make an acquisition like this work.

However, Joel Podolny, the head of Apple University, repeatedly noted that Apple was so big now that change was inevitable; managing and understanding that change would be paramount.

This, then, is what brings this meandering article full circle. Apple Computer the name may have been retired in 2007, but Apple the personal computer company is 38 years old, and very well may have grown as big as it can grow. Is it doomed to simply slowly fade, delivering massive profits and interesting side projects along with a stagnant stock, much like Microsoft in the 2000s? It wouldn’t be a failure of Tim Cook, but more the natural order of such things.

Or are we witnessing a reinvention, into the sort of company that seeks to transcend computing, demoting technology to an essential ingredient of an aspirational brand that identifies its users as the truly with it? Is Apple becoming a fashion house? Think about it: you have Jony Ive as all-up head of design, the equivalent of a Tom Ford or Donatella Versace. There is the hire of Angela Ahrendts – why would she leave the CEO position of Burberry for a Senior VP role? You have an iPhone framed as an experience, not a product. And now you acquire an accessory maker differentiated almost completely by its brand, not its inherent technical quality.

Consider the financial allure: LVMH’s P/E ratio of 21 is low for a fashion brand, yet is 50% higher than Apple’s 14. Tiffany & Co is 62! Moreover, it is high-end fashion that is dominant in the fastest-growing region in the world, Asia, and especially in the fastest-growing country, China. Even with a recent slowdown prompted by an anti-corruption crackdown, China accounted for 29 percent of the worldwide luxury market, although Southeast Asia has recently eclipsed China in growth.

Still, I can imagine the very thought of Apple positioning itself as a fashionable luxury brand is somewhat nauseating for many of my readers. It’s an understandable reaction, and one I somewhat share. I worry that Apple is losing what makes Apple, Apple, especially that desire to make the power of computing accessible for normal people. But I also know that stasis means stagnation, and over the long-run, death.

In the end, I don’t know for sure where Apple is heading, just like I don’t know for sure why they did this deal, but it just might be worth something that they’re headed somewhere.

  1. Microsoft suffered through this problem over the last 15 years ↩

  2. Admittedly, this last one is a bit of a stretch ↩

  3. I am a geek; I own a pair of Sennheiser HD 380 Pros; I am also very aware of how ridiculous they look, and how much cooler every Beats model is ↩

  4. Although there is an inherent tradeoff; it will be fascinating to see if Apple keeps the Android and Windows Phone apps. I suspect not. Apple is a vertical company, which means their services exist to differentiate their hardware, not to be primary money makers ↩

The Week in Daily Updates (Week 3)

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The main page content on Stratechery is free for all readers, but I also offer the Daily Update via email and RSS for $10 per month/$100 per year.1 This is a selection of items that were sent out in this week’s Daily Updates. To sign up, visit the Membership page

Apple Loses Patent Suit

Posted on Monday, May 5

The latest round of the Apple-Samsung patent battle is (mostly) over. From Recode:

The panel ruled that various Samsung products infringed on two patents that Apple had sued over in its latest patent case and found damages on a third patent, awarding more than $119.6 million in damages. However, it found Apple did not infringe on two other patents and also awarded Samsung $158,400, saying Apple infringed on a Samsung patent.

The jury found all accused Samsung phones infringed on the first patent at issue, the ’647 “quick-links” patent, but the devices did not infringe on two others related to universal search and background synchronization. For the ’721 “slide-to-unlock” patent, it ruled some Samsung products infringed, while others did not.

For a fifth patent, the judge had ruled that Samsung’s products infringed on the Apple patent, and the jury determined that infringement was willful.

Meanwhile, the panel ruled that Apple violated one of two Samsung patents that the company had countersued over, but ruled the infringement was not willful and awarded only the $158,400.

There is a lot of spin that “this was never about the money” or that Apple has deterred other infringers by demonstrating that they will irrationally pursue patent cases, but I don’t buy it. I think this is close to a total loss for Apple:

  • It’s very possible that Apple has paid more in legal fees than they have collected
  • If pursuing these patent cases was to somehow make Apple’s employees feel better, then how does this verdict help? Apple may still feel morally wronged, but can barely claim they’ve been legally wronged
  • The (relatively speaking) tiny amount of money that Samsung is forced to pay is likely to encourage future infringers, not deter them. Before these cases Apple competitors feared a patent suit (recall how Android initially lacked pinch-to-zoom). After this, what is there to fear?

I know that most of you reading this likely feel some measure of outrage about Samsung’s design and business practices; however, Samsung clearly does not care, the market does not care, and, ultimately, the courts don’t care. And that’s absolutely a loss for Apple.

The silly thing is that the entire debate sells short what it is that actually differentiates Apple’s products: the entire experience, not just individual features. Maybe it’s just all a distraction for Apple’s competitors to keep them focused on the individual widget, but in all likelihood it’s primarily distracting Apple itself. Time to move on.

Yahoo and Tumblr

Posted on Tuesday, May 6

It’s been a year since Yahoo acquired Tumblr, and the New York Times has an interview with David Karp:

When Yahoo bought Tumblr for $1.1 billion a year ago, it sent a ripple of excitement — and anxiety — through the tech industry. Would Yahoo and its recently arrived chief executive, Marissa Mayer, breathe new life into Tumblr? Or would Yahoo smother the start-up, as it did after acquiring popular young services like GeoCities and Flickr?

So far, the worst fears have begun to dissipate. Tumblr, a microblogging platform, has more than doubled its staff to 220, and its audience continues to grow, up 22 percent in the last year, according to the metrics company comScore.

“The most terrifying thing to me was that this would change the company in any way,” David Karp, Tumblr’s founder and chief executive, said in a recent interview. “But almost a year in, they have lived up to everything they promised.”

Interesting, because my worst fears have come to pass. A year in it looks like Tumblr is a lot like Yahoo: too much undifferentiated and unattractive ad inventory, and not nearly enough customer data.

When the deal happened, I thought it might work out:

Tumblr helps Yahoo catch up. Every Tumblr user has registered with an email address; that email address will be the linchpin for Yahoo’s targeting, especially since they gave up on their own identity system a few years back (YAMM – Yet Another Massive Mistake).

Tumblr is also a great indicator of interests – you follow certain tumbleblogs for a reason, and the fact every blog will be hosted by Yahoo gives them full access to user analytics. More importantly, Tumblr is mobile, and mobile is an information goldmine (interestingly, the Tumblr app does not currently use location services; look for a new “feature” update soon).

It turns out I was wildly optimistic about Yahoo’s ability to leverage that email address into a larger understanding of their user base. The Times article quote Mark Coatney, Tumblr’s former media and business partnerships manager:

He also said Tumblr could be a hard sell to marketers, who like knowing whom they are directing their ads at. This is tricky on Tumblr, because the service does not require people to give more than an email when they sign up for an account. “Real-world identities are valuable to advertisers,” Mr. Coatney said. “Tumblr doesn’t have that.”

Comparing Yahoo’s complete inability to understand its customer’s identity to Google’s success in rolling out the Google+ identity system is as good a contrast as any of just how far apart these once competitors are. Tumblr hinted at a light in the tunnel for Yahoo, but from a strictly business perspective it’s difficult to see the acquisition as anything but a failure.

The full list of topics covered this week in the Daily Update include:

  • Apple Loses Patent Suit
  • Venture Capital and Marketing
  • Unwatched Video Ads
  • Yahoo and Tumblr
  • Alibaba’s IPO Incoming
  • #AmazonCart
  • Level3 and Internet Congestion
  • Dropbox Data Leak
  • Microsoft Surface
  • LINE Results
  • Nintendo Hurting
  • Katie Cotton Retiring
  • Apple Buying Beats?
  • Box Adds GE
  • Comcast to Sell Online Ads

To read all of these updates and to receive future updates, please visit the membership page and sign up!

I’d like to thank all of Stratechery’s subscribers for their support, and for making this site possible.

  1. There is also an access option for $30 per month/$300 per year which gives you access to me personally to ask about the topic of your choosing, a private message board, and virtual and in-person meetups ↩

Dependent on Digital Whales

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It was very hard to find fault with anything that Facebook announced at F8 last week. Unlike their past developer efforts, which were all about pulling content onto Facebook, this year was about pushing Facebook’s infrastructure out into all kinds of mobile apps. The win for Facebook is that much more signal about their users, particularly about their app usage; the win for developers is being a part of the new Facebook Audience Network. The latter is a very big deal.

One of the key lessons I learned working with developers is that, at the end of the day, everything pales in comparison to the question: “How do I make money?” Developer tools are important, languages are important, exposure is important, but if there isn’t money to be made – or if more money can be made elsewhere – then you’re not going to get very far in getting developers on your platform.

Facebook, meanwhile, is crushing it when it comes to mobile revenue. In the last quarter, mobile ad revenue surpassed non-mobile ad revenue for the first time, bring in nearly $1.3 billion dollars. As I noted last week in a piece on Bloomberg View, “These ad units are largely purchased by free-to-play game publishers such as King (maker of Candy Crush Saga) and Big Fish Games, which leverage Facebook’s incredible demographic data to target the small percentage of players who will spend hundreds of dollars on in-app purchases.”

Both Google and Twitter are looking to edge in on Facebook’s territory; Twitter launched app install ads of their own last week, and Google is doing the same for search and YouTube, with the killer advantage of knowing exactly which apps Android users are already using.

Meanwhile, Google and Apple are both raking in 30% of every virtual sword and extra life, and Apple in particular isn’t shy about talking about it, continually bragging about the amount they have paid out to developers with nary a mention that 95 of the top 100 apps1 are free-to-play.2

So to recount, Facebook is going gangbusters because of ads for free-to-play games, developers are excited about the chance to cash in via Facebook ads, Google and Twitter are trying to mimic Facebook’s success, and Google and especially Apple are hanging their app store hats on the amount of revenue generated by in-app purchases.

App stores take 30% of in-app purchases; the remainder goes to free-to-play publishers like King. These publishers, in turn, drive the majority of Facebook mobile advertising, as that is the best channel to find more digital whales. And now, 3rd-party developers can get their piece.
App stores take 30% of in-app purchases; the remainder goes to free-to-play publishers like King. These publishers, in turn, drive the majority of Facebook mobile advertising, as that is the best channel to find more digital whales. And now, 3rd-party developers can get their piece.

In other words, billions of dollars in cold hard cash, and 20x that in valuations are ultimately dependent on a relatively small number of people who just can’t stop playing Candy Crush Saga.

  1. As of May 9, 2014 ↩

  2. Technically, not all are “free-to-play”, which means games; there are some freemium applications as well, but the overwhelming majority are games ↩

Apple Retail and the Innovator’s Dilemma

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Angela Ahrendts officially took over as head of Apple Retail last week, and just in time. Same store sales were down five percent last quarter, and have been hovering around zero for several quarters prior. To be fair, that decline is mostly due to Apple’s slowed growth; more concerning is the declining rate of store openings: 37 in 2011, 40 in 2012, but only 24 in 2013. Most concerning is the paucity of locations in Asia, the fastest growing region in the world; Apple only has 19 stores in Japan, China, and Hong Kong.

It’s easy enough to dismiss the importance of the Apple Stores; after all, if sales move largely in line with Apple’s top-line revenue, surely they are simply another channel, no? Sure, Apple’s relative share for all of its products roughly corresponds to the number of Apple Stores in a particular region, but again, might that not be a trailing indicator?

I would argue no. In fact, as much as people have come to appreciate Apple Stores, I believe that they are not only still undervalued, but actually increasing in importance; moreover, Ahrendts is a potentially valuable addition not just because of her experience opening stores in Asia, but because of the type of company whence she came.

Over the last few years, as Apple has retained its dominance of the high end in all the sectors it competes in, some (not all) former doomsayers have come to begrudgingly accept that perhaps not all consumers are focused solely on price (how said doomsayers manage to ignore nearly every other consumer product category is beyond me). Instead they have seized upon tech’s favorite word “disruption” as the cause of Apple’s certainly impending slide. The argument goes something like this:

“OK, I will grant you that Apple has locked up the premium end of the market. However, even basic smartphones are increasingly ‘good enough’; Apple will soon be over-serving the market. No one will want to pay $650 for a smart phone, no matter the brand, especially if operator subsidies go away.”

Leaving aside the operator subsidy question (I’m of the opinion operators like them more than they let on), this criticism of Apple is sound in theory but mistaken in reality; the truth is that Apple doesn’t sell phones (or computers or tablets); they sell iPhones. And iPhones are not just hardware, but also the software that runs on them. But even that is missing the whole picture. To buy an iPhone is to buy into an experience that includes everything from advertising to following the news to visiting a store to buying a phone to unboxing to downloading apps to visiting a genius and so on and so forth.

It’s no accident that the Apple Store appears twice in that sequence. It’s a critical part of the Apple experience that increases the value of an iPhone (and Mac and iPad) and works in a very specific way to counteract over-serving and help prevent disruption.

In the “Innovator’s Solution,” the follow-on to “The Innovator’s Dilemma,” Clay Christensen diagrammed the process of low-end disruption:

The incumbent product is originally not good enough, but over time it improves and eventually over-serves consumer needs. This leaves room for the good-enough lower-prices new entrant.
The incumbent product is originally not good enough, but over time it improves and eventually over-serves consumer needs. This leaves room for the good-enough lower-prices new entrant.

The market leader (in this case, the iPhone) starts out not good enough, but better than anything else. Over time it improves, until it perfectly meets consumers needs. However, driven by the need to maintain profit margins and the demands of high-end consumers, the product continues to improve beyond what most consumers value. Meanwhile, new entrants are not as good, but also cheaper; they begin to peel off the lower end of the market, and as they improve, eventually take it all.

Certainly low-cost phones powered by the various flavors of Android have been very successful in the low-end market, and there’s no question that a great many consumers are first and foremost driven by price. However, the iPhone has stubbornly held on to the high end, even increasing its share. As I wrote in What Clayton Christensen Got Wrong:

Not all consumers value – or can afford – what Apple has to offer. A large majority, in fact. But the idea that Apple is going to start losing consumers because Android is “good enough” and cheaper to boot flies in the face of consumer behavior in every other market. Moreover, in absolute terms, the iPhone is significantly less expensive relative to a good-enough Android phone than BMW is to Toyota, or a high-end bag to one you’d find in a department store.

It’s that last example that resonates when talking about retail especially. To buy a designer bag is an event: you’re greeted at the door, given a drink, have an attendant on hand at all times (who will model the bag for you, if need be); if you purchase it’s almost like a ceremony, complete with special packaging, congratulations (for them taking your money!), and perhaps a follow-up call a day or two later. Obviously given its scale an Apple Store isn’t quite the same, but it’s in the ballpark, especially relative to the buying experience for most electronics. Moreover, it’s the after-sale experience that is arguably the best part: you’re given help setting up your new device, transferring files, invited to classes to learn how to use your purchase, and assured that a genius is ready-and-waiting to take care of any problems that arise.

All of this activity surrounding the Apple Store has a direct effect on all three disruption curves:

The “try-before-you-buy” accessibility of the Apple Store raises the customer needs curve

By being able to experience new features in the Apple Store, consumers come to demand those features, effectively increasing consumer needs
By being able to experience new features in the Apple Store, consumers come to demand those features, effectively increasing consumer needs

My favorite example of this is Facetime when it first launched: Apple actually set up a special 1-800 number that you could call to try out Facetime from any Apple Store. Instantly Facetime moved from being something abstract to being something real, and something you just had to have.

This is an area where Apple Stores are going to be increasingly critical. Our computing devices are becoming more and more personal, particularly the (alleged) iWatch, and making that experience real to potential customers at scale will be a big challenge (this was one of the many reasons why the Facebook First was a failure). This is also an area where the Apple Store has slipped; the TouchID in-store demonstration is pretty weak, in my opinion, especially compared to the Facetime example. Still, thanks to its stores Apple is alone in its ability to make these kinds of features must-haves.

In-Store education lowers the Apple products’ feature curve

Workshops and Apple Store employees enable consumers to use more features; previously unused features (that would have been over-serving) now are consumer needs
Workshops and Apple Store employees enable consumers to use more features; previously unused features (that would have been over-serving) now are consumer needs

Although Apple is famous for its focus on simplicity, the reality is computers are complicated, and that includes iOS devices. It’s very easy for less tech-savvy consumers to never really use a large percentage of their device’s capabilities, increasing the risk that they see the price premium as not being worth it (leaving aside the fact the cheaper products are usually more complex).

Enter Apple Store Workshops. One-to-many classes are available for free, and one-to-one for $99/year. I’m sure few of you reading this have even given these classes a second-thought, but my dad sure has; they completely changed his relationship with the iPad I gave him, and became something he really looked forward to. He told me, and I quote, “It’s the first time in my life I haven’t felt like an idiot [with a computing device].” And, ever since, he’s been counting the days until he can get what-he-previously-considered-to-be-an-overpriced iPhone. It’s worth it, because he knows he can learn how to use everything it has to offer.

The Genius Bar “safety-net” lowers the relative value of low-end products

The lack of something similar to the Genius Bar makes low-end products a much less attractive alternative
The lack of something similar to the Genius Bar makes low-end products a much less attractive alternative

I don’t know about you, but one thing I’ve realized as I’ve gotten older is that the non-technical dislike calling you for support just as much as you dislike being called. That’s one of the biggest reasons why it’s hard to overstate the impact of the Genius Bar. Even if you never visit, the knowledge that you can if you buy an Apple product, but that you can’t if you buy another, significantly diminishes the relative value of the competing product. Numerous industries have been built on the premise that people will pay for peace of mind, and the Genius Bar is no different. The lack of something similar means that competing products may be good enough from a feature perspective, but in the full calculus of the overall ownership experience never can be.

What is particularly compelling about each of these factors is that they work to Apple’s advantage even if you don’t buy your Apple product from an Apple Store. You can try out a product there, then order it online. You can take a class with a second-hand device, and you can visit the genius bar no matter what. Thus, I don’t think looking at direct Apple Store sales fully captures the impact they have on Apple’s business.

That said, anecdotally speaking (albeit echoed in numerous places), visiting an Apple Store is not quite the experience it once was. Many are crowded, it’s confusing to check out, and the product presentation is feeling a bit tired. There is significant room for improvement in current stores, improvements that makes them feel even more like the premium retailers they are. Enter Ahrendts, recently-departed CEO of Burberry, purveyor of the sort of experience the Apple Store has long emulated.

I actually agree with the consensus that Ahrendts success in Asia broadly and China in particular were major factors in her hiring, but don’t discount what she might improve in the stores that already exist. While I disagree with those that say Apple’s disruption is imminent, I’m not one to ignore the possibility; I do think, though, that even these more nuanced doomsayer serially underestimate the totality of the Apple experience, of which Retail is and will continue to be a major part.

Note: I first introduced many of these ideas in a 2010 paper called Apple and the Innovator’s Dilemma